Insights

What is Happening to Oil and the Markets?

The stock market has descended into correction territory as 2016 has unfolded. What role are lower oil prices playing? If it’s not all about oil, then what else is behind the market’s stress?

Here is our take on oil and the markets, and how we are reacting to the sell-off. Whatever the causes, we agree that times like these feel awful. The best defensive strategy is to make sure that your portfolio is invested in a manner consistent with your needs and goals.

Why is the price of oil falling?
• It’s about supply and demand — the world is pumping out more oil than it currently needs and storage facilities are reaching capacity.

• Demand generally grows along with the world economy, and is less sensitive to price than you might expect. Measures that improve energy efficiency (automobiles and industry) have weighed on demand growth.

• It takes time and lots of money to produce more oil. Global supply has ramped up in recent years, only to encounter a sputtering Chinese economy.

What’s happening in the oil fields?
• As prices fell from $50 to $30 per barrel, many producers in North America, the North Sea and around the Caribbean basin became unprofitable. They are now at the point where their day-to-day cash flow is turning negative.

• In 2015, 60% of US shale rigs were idled, yet production only fell 4%. With prices falling and hedges (contracts to sell oil made when prices were higher) expiring, production is expected to drop by at least 8% in 2016.

• Unneeded oil is now being shipped to the only two places with remaining storage capacity – the US and China. Prices could collapse further – perhaps much further – if we get to the point where all the tanks have been filled. In that event, we would expect to see capitulation in the form of significant production cuts, and then a quick recovery for prices.

• Global supply and demand could be in balance by year-end. That might mean a price closer to $50 per barrel. Deep cuts to exploration and production budgets today should eventually translate into higher prices a few years out.

• As we write, Iran is suggesting it would support a production ceiling to stabilize oil prices. We may also see a strategy shift by the Saudis, who until now have been unwilling to concede market share to other producers. Or, escalating Middle East turmoil could interrupt production, sending oil prices higher.

What’s wrong with falling prices?
• For oil producers, including the US and Canada, oil patch layoffs and spending cutbacks are hurting local and national economies.

• Financial distress is being felt in high yield (junk) bond markets where the energy sector has a large presence, and by regional and national bank lenders. Numerous energy-related bankruptcies and defaults are anticipated to unfold this year.

• Many oil exporting nations built up cash reserves over the past decade and created investing vehicles known as sovereign wealth funds (SWFs). After using oil profits to buy global stocks and bonds, they shifted to selling in 2015. Analysts at JP Morgan estimate that SWFs will need to liquidate $120 billion worth of bonds and $80 billion in stocks over the course of 2016. $80 billion is just a little more than one-tenth of 1% of the value of the world’s stocks, but the presence of a price-insensitive seller has contributed to the recent pessimism.

Knock-on effects, real and perceived
• Oil’s decline is reinforcing what has for the moment become a negative feedback loop of lower and lower expectations. The circle of factors now includes sluggish economies, negative interest rates, Middle East/Korean unrest and an unraveling China.

• The negativity and the stress evident in many financial markets are overshooting reality. US banks are already priced to reflect energy loan write-offs, and now are trading as if US interest rates are going to zero and staying there. Industrial stocks have likewise fallen to recessionary levels. Things are far from perfect, but this is not 2008 – bank earnings may suffer, but their existence isn’t threatened.

• We hope that economies and markets are slowly adjusting to a world where central banks provide less support for investors, either because they no longer think it prudent, or because monetary stimulus has lost its impact. However, even the perception that central banks no longer “have the market’s back,” can put pressure on asset values. We need to get away from relying on such support, which will eventually lead to a firmer foundation for risk-taking.

• Perhaps today’s biggest risk is, to quote FDR, “fear itself.” In today’s interconnected world, the latest developments are reported with an urgency that seems to require action – “Sell! Buy! Sell!” – and so on. Moreover, a falling market is taken as a sign that something’s wrong with the world. Businesses may become cautious, delaying new projects and putting off hiring. Investors look to reduce risk until there is more clarity.

• Energy workers are losing their jobs and energy investors are losing their shirts. Yet behind the scenes, the issues facing the oil industry are on their way to resolution. The energy industry will reinvent itself in a more financially responsible way, and hopefully many of those workers will find jobs. Prices will recover to a level that balances supply and demand, but are much less likely to soar past $100 as shuttered supply will reappear faster than in the past.

• Consumers, meanwhile, are benefitting from lower prices at the pumps and smaller home heating bills, freeing up cash flow for spending on non-energy related goods and services.

What we’re doing
• While we don’t view falling oil prices as a significant concern per se, we are worried that China’s economy will continue to slow and we believe that currency devaluations this year remain a distinct possibility. Our bias is to avoid additional exposure to global industrial, materials and technology investments until we have more clarity on China.

• At home, mixed economic data are also concerning. With the industrial economy already in recession, healthy consumer spending has to carry the US economy. Until we see more evidence of such a slowdown, we have to characterize the current sell-off as a major league growth scare.

• “Buying the dips” has been a great strategy for navigating the financial markets for the past seven years. Our tendency to be selective has caused us to miss a few of those dips. We believe that monitoring risk is especially critical in the current environment – we will leave return-chasing to others.

• We maintain our belief that remaining invested and patiently navigating the day-to-day volatility is the way to approach all markets. What we own will change as markets move. Today’s markets feature plenty of “for sale” signs – we are shopping for lower-risk bargains.

Are we on course?
• While investing strategies should not be discarded in response to panicked markets, we recognize that it’s completely human and natural for investors to react with concern. Protection of principal, otherwise known as “survival,” is always critically important.

• Financial goals and needs exist independent of what’s happening in the markets. For this reason, we suggest that discussions about investing strategies and market risks should begin with a review of those needs and goals.